Topic 3: Bank Regulation Flashcards

1
Q

Basel Committee (BCBS)

  1. BIS
  2. BCBS
  3. Challenges
A

• Bank for International Settlements (BIS)
– The “Central Bank for Central Banks”, Established in Basel Switzerland in 1930
• Basel Committee on Banking Supervision (BCBS)
– Established at BIS in 1975, but distinct from it / No direct legislative power, issues “guidelines” / Implemented into law by national regulators
• Challenges
– Creating regulation for economies in different states of development
– International banks subject to similar, but not identical, regulatory frameworks
– Significant risk of unintended consequences (complex system)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q

Regulatory Lessons from the Crisis

Themes: global stability / liquidity / quant models / incentivisation

A

– Global financial system is highly interconnected (Not just about individual bank)
– Participants in that system will assume the worst if those linkages are uncertain
- Liquidity
- Quantitative models are not a panacea: garbage in/garbage out, black swans
- Disaster plans need to be credible, and tested
- Conduct is driven by perceived incentives (personal cost vs personal benefit)
– Accountability matters

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q

Classes of Bank Regulation (4)

A

• Prudential
Bank solvency – ability to pay all debts eventually
Restricts leverage (which limits profits)
Economic lever to direct bank behaviour via “capital charges”
• Liquidity
Pay near‐term debts on time as they become due
Lack of liquidity can lead to solvency issues
• Disclosure
Before 2007/09 crisis, disclosure seen as a primary mechanism for conduct regulation
• Conduct
Post 2007/09 crisis, explicit conduct regulation and accountability has been the growth area
Regulators no longer rely so heavily on transparency alone to steer behaviour

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q

Bank Prudential Regulation

  1. Aim is..
  2. Basel Accord is defined in terms of..
  3. Min capital - now, increase to…
A
  • Aim is a risk‐sensitive leverage ratio
  • Basel Accord defined in terms of a scaled quantity ‐ “Risk‐Weighted Assets” (RWA)
  • Minimum capital defined as a fixed fraction of total RWA, including non credit risk RWAs
  • The prescribed fraction is currently 8% (Pillar 1) but will rise to ≥ 10.5% by 1 January 2019
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
5
Q

Name the Three Pillars of the Basel regulatory regime

A
  1. Pillar 1 – Minimum Capital Requirements
    a) a fraction of the bank’s RWA levels, which are in turn calculated via prescribed processes
  2. Pillar 2 – Supervisory Review
    a) Regulator’s opinion on the safety of the bank, expressed as an additional capital amount.
    Includes regulators’ view of how well risk management processes are functioning
  3. Pillar 3 – Disclosure and Market Discipline
    Requirement to disclose information regularly to market in a standard format
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
6
Q

Three Pillars approach

  1. Was for capital, now also for…
  2. How to incentivise behaviour
A

1 Originally just for capital, but 3 pillars approach now also adopted for liquidity regulation
2 To incentivise behaviour, Pillar 2 capital overlays have to be linked to management actions

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
7
Q

Pillar 1 (prescribed by formula) - List examples of:

Types of Capital
- Tier 1 (Going Concern) Capital to absorb losses without placing the bank into insolvency or liquidation

  • Tier 2 (Gone Concern)
    Capital that can absorb losses during insolvency but before debt investors incur any loss
A
  1. Tier 1 (Going Concern) >= 6% RWA
    - Common Equity Tier 1 (CET1): Highest quality capital, incl common shares and ret’d earnings. >=4.5% RWA (Pillar 1)
    - Alternative Tier 1 (AT1)
    Ranks above CET1, but subordinate to other
    liabilities ‐ incl “Contingent Convertibles” (CoCos) that automatically write down or convert to equity in times of stress
  2. Tier 2 (Gone Concern)
    - Tier 2 (T2)
    subordinated term debt of 5+ years original maturity, general loan loss provisions (capped)
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
8
Q

Pillar 1 (prescribed by formula)

  • Contingent Convertibles (Cocos) / Alt Tier 1

QN: List the 2 key parameters

A

• Two key parameters:
1. Trigger Event: instigates conversion process – may be objective and/or discretionary
2. Loss Absorption Mechanism: conversion to equity (typical) or write‐down of principal
– Many variations, and up to issuer to structure an instrument attractive to the market

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
9
Q

Pillar 1 (prescribed by formula)

Capital Buffers - list types

A

– Cap Conservation Buffer (CET1 = +2.5% RWA)
bank keeps operating but with restrictions on staff bonuses + dividends
– Sector‐Specific Buffers (UK)
Cap charge on lending to sectors of the economy that would create risk to the financial system
– Countercyclical Buffer (CET1 up to +2.5% RWA)
Additional cap to be built up countercyclicaly
– Systemically Important Buffer (CET1 up to +4.5% RWA in USA, +3.5% RWA in Europe)
Additional cap to ensure systemically important banks are safer
• Last three examples of “macro‐prudential” regulation – targeting financial system as a whole

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
10
Q

Pillar 1 (prescribed by formula)

Buffers, from 1 Jan 2019
- list stack

A
(stack)
* Countercyclical (up to 2.5%)
* Systemically important (up to 4.5%
* Capital Conservation (2.5%)
* Max T2 (2%)
Max AT1 (1.5%)
* Min CET1 (4.5%)
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
11
Q

Pillar 1 (prescribed by formula)

Buffers, from 1 Jan 2019

  • Capital range on RWA including buffers
  • RoE =
  • Impact on RoE
A
  • Capital moves from current 8% RWA to a range of 10.5% ↔ 16.5% RWA
  • Gross return‐on‐equity (RoE) from lending = margin x leverage
  • Assuming margins and risk weights stay constant, then some gross lending RoEs could halve
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
12
Q

Pillar 1 (prescribed by formula)

Basel 3 has introduced new classifications: (sometimes overlapping)

A

– SIFI (“Too‐Big‐To‐Fail”)
Systemically Important Financial Institution – colloquial umbrella term for banks, insurers, etc.
– G‐SIBs and D‐SIBs (BCBS)
Global / Domestic Systemically Important Banks ‐ the global G‐SIB list currently contains 30 banks
– G‐SIIs (EBA)
Global Systemically Important Institutions – assessed at a consolidated group level
– O‐SIIs (EBA)
Other Systemically Important Institutions ‐ assessed at either a consolidated or subsidiary level

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
13
Q

Pillar 1 (prescribed by formula)

  • Current List of G-SIB and D-SIB
  • APRAs current buffer settings
A
• No Australian banks in G‐SIB list
• Four D‐SIBs in Australia
– ANZ
– NAB
– CBA
– WestPac
• APRA’s current buffer settings:
– D‐SIB = 1% RWA
– Countercyclical = 0% RWA
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
14
Q
Pillar 1 (prescribed by formula)
Total Loss Absorbing Capital (TLAC)
  • define
  • applies to:
  • includes what types
  • Australia?
A

• more expansive definition of loss‐absorbing assets, with constraints applying only to G‐SIBs
• TLAC can be cap or qualifying unsecured long‐term sub debt (not just cap)
* long term (> 1 yr) sub debt + CET1 + AT1 + T2
• Cap absorbs the loss, and defaulting on lowest tier of debt then sufficient to recapitalise
• Extensive rules to address parent‐subsidiary structures, cross holdings, etc.
• From 1 Jan 2019: TLAC ≥ 16% RWA and ≥ 6% total assets (twice the Pillar 1 capital measures)
• APRA asked to look explore a similar regime for Australia, but no firm deadline imposed

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
15
Q

Pillar 2 (assigned by regulator)

MREL (Europe)
- define

A

• MREL = “Minimum Requirement for Own Funds and Eligible Liabilities”, part of the “Bank Recovery and Resolution Directive” (BRRD)
• Similar to TLAC (recap by default on sub debt), however MREL is:
– Euro std, all banks and investment firms, not just G‐SIBs
– Expressed in terms of total liabilities, not risk‐weighted
• European G‐SIBs (13 of the 30) will have to comply with both
• Also represents significant work for regulators:
– BoE to set MREL for all banks, building societies, and 730k investment firms

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
16
Q

Pillar 2

MREL - instruments

A
  • Ranks above T2 (and hence above AT1 and CET1), but below senior unsecured bonds
  • Terms allow principal to be written down in resolution, or converted to a more junior liability
  • Not a CoCo (AT1) as trigger for write down is that the bank no longer a going concern
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
17
Q

WACC

  • define
  • tax term
  • only an approximation because..
A

• average cost of funding across all liability types
• Tax term recognises that debt servicing, including AT1 and T2, is a pre‐tax cost – unlike equity
• Only an approximation as K will have a dependency on the composition of the balance sheet
– Market will demand a higher return to lend to a bank that is already highly leveraged
• Useful as a marginal measure – lending at less than current WACC will reduce profitability

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
18
Q

Economy of Scale vs Too big to fail

A

• Research indicates growth can deliver at least as much benefit to bankers as to investors [1]
• Direction of regulation post‐crisis is to work against this, to discourage “too‐big‐to‐fail”
• G‐SIB/G‐SIFI status is one aspect of this – extra capital – but also extra costs, reporting etc.
• One response is to split into smaller (connected) companies that remain part of a group [2]
- regulators nervous about outsourcing

19
Q

Key points - Prudential regulation

  • requirement for banks to…
  • reduces overall profitability because..
  • impacts = uniform?
A
  • Banks to hold more cap to absorb losses and protect from insolvency
  • Cap = higher quality to function when needed
  • Cap to absorb losses to be backed up by “defaultable debt” to recapit post insolvency
  • Reduces overall banking sector profitability, and assigned risk weights will influence lending
  • Impacts are not uniform, but instead are targeted at largest institutions (“too‐big‐to‐fail”)
20
Q

Pillar 1: Liquidity Regulation

Why is Liquidity Important - difference between solvency and liquidity

A

• Solvent = able to pay all debts eventually → assets are of sufficient value to cover debts
• Liquid = able to pay near‐term debts as they become due → assets can be turned into cash
Solvent + Liquid = Going Concern

21
Q

Pillar 1: Liquidity Regulation

Define Liquid but insolvent

A

LT problem, but may have time to solve (e.g. asset values recover)
• Accounting rules and corp leg’n should force insolvency
• In practice for banks, often better to try to recuperate (e.g. WestPac 1992)

22
Q

Pillar 1: Liquidity Regulation

Define Solvent but not liquid

A
  • Immediate problem, will need to sell long‐term assets (quickly) to pay debts
  • Easiest to sell the best assets, depressing the av quality of assets held
  • If sale is at a discount, may mean remaining assets re‐valued downward
  • In extreme cases for banks, this can trigger market panic (e.g. Lehman 2008)
23
Q

Pillar 1: Liquidity Regulation

Define not solvent / not liquid

A

• No longer viable (“gone concern”)

24
Q

Pillar 1: (set by rules rather than regulatory direction)

Liquidity Coverage Ratio (LCR)

A
  • Ratio of avail cash and govt securities to f/c net outflows over next 30 days
  • Qualifying assets = High Quality Liquid Assets (HQLA)
  • LCR ≥ 100% and defined that flows occur in stressed conditions, so deposits are drawn down
25
Q

Pillar 1: (set by rules rather than regulatory direction)
Liquidity Regulation
Net Stable Funding Ratio (NSFR)

A
  • Ratio of amt of “stable” (longer term) funding to that required by bank’s less liquid assets
  • Intended to limit the amount of maturity transformation on banks’ balance sheets
  • NSFR ≥ 100% but valuations calibrated to un‐stressed conditions
26
Q

Pillar 1: (set by rules rather than regulatory direction)

LCR Calc
- Net Cash Outflows

A
  • Assume funding runs‐off in stressed conditions
  • Funding with > 30 days to first draw down opportunity are not considered
  • Retail demand deposits assigned the lowest run‐off rates, but further divided into “stable” and “less stable”
  • Higher run‐off rate for funding from commercial customers
  • ST funding from other banks and fin instos assumed 100% drawn down
  • Inflows (e.g. from rev‐gen assets) reduced to ≤ 75% of non‐stressed values
  • Inflows from HQLA (i.e. that appear in the numerator) must be excluded
27
Q

HQLA:
2 levels
2 sub levels

A

Level 1: >= 60%
- Cash, CB reserves, and certain sovereign‐backed debt instruments, valuations 100% weighted
Level 2: =

28
Q

Committed Liquidity Facility (RBA)

A

• Aus: not enough HQLAs - Aus govt debt is low
• Aus has a net CAD but it is funded via the commercial banking system
• RBA and APRA developed the CLF
• Allows banks to pre‐position assets for CB repo, at known rates:
‒ 15bp ongoing fee on total facility amount, and cash rate +25bp on any drawn amount
• APRA recognised the CLF in its implementation of the LCR (APS210)
• South Africa has also implemented CLFs, for the same reason

29
Q

Net Stable Funding Ratio

A

NSFR = Value of Avail Stable Funding / Value of Required Stable Funding

ie ASF / RSF

NSFR >=100%

30
Q

Net Stable Funding Ratio

List Required Stable Funding (RSF) Factors

A
  • weighting ranges from 0% for coins / banknotes / CB reserves to 100% for encumbered assets >1 yr and other assets
31
Q

Net Stable Funding Ratio

Available Stable Funding (ASF) Factors

A

ASF weights components, assessing the term 1 year) and stability of instrument (eg stable and less stable deposits)
ALso - funding by sovereigns or non financials, etc.
• NSFR and LCR split non‐term deposits into “stable” and “less stable”, where former includes
retail customers with broad bank relationships or with transactional accounts (e.g. salaries)
• This means there is an economic benefit to being your customers’ primary transaction bank
* Note funding cliffs, as various instruments roll down the curve and are weighted differently (eg at the 6 month and 1 year point)

32
Q

Strategies to Increase NSFR

List 2

A
  1. Increase Available Stable Funding (ASF)

2. Decrease Required Stable Funding (RSF)

33
Q

Strategies to Increase NSFR

- Increase Available Stable Funding - eg…(3)

A
  1. Increase Share of Deposits (and increase share of stable deposits vs less stable deposits)
  2. Extend maturity of wholesale debt > 1 year
  3. Increase share of Tier 1 capital
34
Q

Strategies to Increase NSFR

- Decrease Required Stable Funding - eg…(3)

A
  1. Shrink the Balance Sheet (shrink loan portfolio; sell assets that are 100% funded)
  2. Change composition of investments (sell lower rated investments for cash, replace lower rated investments with higher rated)
  3. Change composition of loans (substitute retail loans with corporate loans and mortgages, reduce maturity of corporate loans to
35
Q

Liquidity Regulation

  • available liquidity changes after every transaction
  • monitoring is continuous

Qn
List steps in the definition of LCR and NSFR
Is knowing LCR and NSFR now sufficient?

A

• There are a series of “steps” in the definitions of both LCR and NSFR:
‒ The 30 day LCR window
‒ The 6 month and 1 year residual maturity criteria embedded in the ASF of the NSFR
• Introduces “cliff risk” on the passage of time – step changes as cash flows enter/exit windows
 Not sufficient to know LCR + NSFR now, also need to forecast their values in the future
 Liquidity needs to be built into internal pricing models (FTP), and design of products

36
Q

Pillar 1: Mostly built on categorisation - assets
RWA Assets
HQLA Assets

A
RWA ASSETS are a function of...
• Obligor Type
• Obligor Credit Rating
• Collateral Type
• Collateral Value (Real Estate)
• Original Maturity (Interbank Loans)
HQLA ASSETS are a function of...
• Asset Type
• Encumbered Status
• Obligor Type
• Obligor Credit Rating
37
Q

Pillar 1: Mostly built on categorisation - assets

  1. Expected Inflows - 30 days
  2. RSF
A

Expected Inflows: 30 days
• Asset Structure
• Obligor Credit Rating
• Time of Estimate

RSF
• Obligor Type
• Asset Type (inc. HQLA + RWA categories)
• Encumbered Status and Timescale
• Residual Maturity
38
Q

Pillar 1: Mostly built on categorisation - Liabilities

  1. Capital Seniority and Class
  2. Stressed Outflows (30 Days)
A
  1. Capital Seniority and Class is a function of Instrument Type
  2. Stressed Outflows (30 Days) is a function of
    • Liability Structure
    • Cost Structure
    • Stressed Assumptions
    • Time of Estimate
39
Q

Pillar 1: Mostly built on categorisation
Liabilities (ASF)
Assets (RSF)

A
ASF is a function of: 
• Investor Type
• Liability Type (Capital or Debt)
• Stability Classification
• Residual Maturity
RSF is a function of 
• Obligor Type
• Asset Type (HQLA + RWA categories)
• Encumbered status & timescale
• Residual Maturity
40
Q

Pillar 2

1. UK Pillar 2 - 2 subcomponents

A

Subcomponents
– Pillar 2A – Risks not fully captured in Pillar 1
(pension risk, concentration risk, interest rate risk in the banking book (IRRBB), etc).
Banks estimate, with guidance from regulator
– Pillar 2B – Additional risks a bank may become exposed to over its planning horizon. Stress test.
• Pillar 2 is part of the “floor” capital requirement upon which the capital buffers are applied
• Pillar 2 outputs are generally confidential and banks not permitted to disclose (their “score”)
• Regulators cooperate on common guidelines for Pillar 2 for consistency

41
Q

Omission from Pillar 1: Concentration Risk:

  1. Banks monitor concentration by…
  2. Regulators use…
  3. Be cautious of..
A
  1. Banks monitor concentration by…measuring concentration in industry, geography, exposure
  2. Regulators use…Herfindahl-Hirschman Index (HHI) = sum of the weights of each category
  3. caution: classifications: eg petroleum / petroleum manufactured products / retail petroleum products could be classified as Mining / Manufacturing / Retail, yet risks would be correlated
42
Q

Issues with Interbank Trading and Derivatives

  1. Most derivatives are:
  2. Issues with ___________ and ___________
  3. Difficulty obtaining ______________during the crisis
  4. Regulatory Reponse has been 2-fold: a)______ b)____________
A
  1. Most derivatives are: OTC
  2. Issues with transparency and credit risk (not factored in)
  3. Difficulty obtaining fully netted derivatives and swap positions during the crisis
  4. Regulatory Response has been 2-fold: a) INFRASTRUCTURE: centralise trading with a capital charge on derivs b) discourage complex, non standardised products
43
Q

Central Clearing Counterparties (CCPs)

  1. Bilateral trades replaced with:
  2. How is a default covered
  3. Requires…
A

1…replaced withpairs of back‐to‐back trades with a central counterparty (CCP)
2 Participating banks finance a reserve fund at the CCP to cover a bank defaulting on its trades
3 Requires traded products to be standardised